Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Tuesday, December 17, 2013

Recent U.S. Data Indicates 2013 Limping To the Finish Line

Most users of the mainstream media
are vaguely aware of the constant stream of economic data reported between
crucial updates on the Kardashians and other drivel that currently passes for legitimatenews.
With arcane names such as the Purchasing
Managers Index and New Orders for
Nondefense Capital Goods less Aircraft, it is easy to see why much of these
data can cause otherwise inquisitive eyes to dart straight to the sports
section. But taken in aggregate, and over an extended period of time to smooth
out inherent volatility, such data tell the tale of the condition of the
economy, its bright spots and areas of lingering weakness. Recent numbers, at
least at first pass, have been encouraging. Yet when applying slightly greater
scrutiny, one uncovers wounds that have been difficult to heal.

GDP: Stuck on Low Gear

One recent headline-grabber was the
upward revision of Q3 GDP growth to 3.6% annualized. Quite an improvement over
the previous five quarters, where growth averaged 1.5%. But before declaring an
American wirtschaftswunder, it is
necessary to point out that inventory build-up…that is goods produced but have
yet to find a home….accounted for one-half of the gain. Filtering out inventory
factors, a more pedestrian rate of 1.8% is in line with the roughly 2% growth
in which the country has been trapped since 2011.

History indicates that excessive
inventory gains tend to suck growth out of ensuing periods as prudent managers
whittle down warehouse levels. That adversely impacts everything from worker
hours and electricity usage in factories to fuel demand for the nation’s
trucking fleet. High inventory levels also can lead to price slashing to move
products, which cuts into corporate profit margins.

One way gauge the economy’s
heartbeat at its most basic level is the Final
Sales to Domestic Purchasers data series (speaking of arcane titles).This
scrubs out the effects of both inventory gyrations as well as exports, in order
to determine how willing American households and managers are to open up their
wallets. As seen below, for five of the past seven quarters, final sales have
lagged top-line GDP growth. For Q3, Final Sales growth was 1.8%, which is what
it has averaged since the beginning of 2011, compared to slightly higher…but
still forgettable…2.1% for the overall economy. For some perspective, Final
Sales averaged 2.9% between 2000 and 2006 when the economy was chugging along
at a 2.6% clip.

Business Investment: The Real Driver of the Economy

While personal consumption accounts
for roughly 70% of the U.S. economy and often is used as a proxy for the
overall health of the marketplace, the real engine for durable, long-term gains
is business investment. Not only does such investment lead to productivity gains,
which in turn leads to a more skilled workforce and higher wages, but also
complex manufacturing is one of the sectors in which the U.S. still ranks among
the global elite. That along with ever-creative ways to improve the
cheeseburger. It is healthy for the country to have sleek, automated factories
producing precision-crafted capital goods (often for export) rather than
churning out volumes of low value products like t-shirts and rubber duckies. The
broadest investment category in GDP data has registered strong gains over the
past several quarters, but much of that is due to a rebound in the residential
housing sector, which is peculiarly lumped into this bucket. Much of housing’s
gains are due to a pronounced base effect after the sector spent years in the
dumps. A number which more cleanly captures output of products like capital goods
and computers is the business equipment series. After having been a strong
contributor to growth in the wake of the recession (again partially due to
pathetic 2008 and 2009 base effects), such investment has cooled dramatically
over the past year, with Q3 investment being flat.

From 2000 to 2007 investment in
business equipment averaged 4.2% annualized. A consistent return to such levels
would signify confidence by the nation’s businesses that growth prospects are sufficient
to justify ramping up purchases (often on credit) of machinery, computers and
logistical equipment. While investment in business equipment has belatedly
clawed its way back to its pre-crisis proportion of the broader economy, real
estate has not. As seen below, during the bubble years, residential real estate
investment rose from 5.2% of GDP to over 6%, eclipsing business equipment
investment for much of that period. Since then it has dropped to the 3% range.
Given the structure of the U.S. economy, residential investment is joined at
the hip with personal consumption, partly due to the need to outfit housing
with furniture and neat gadgets like turbocharged espresso machines, and partly
due to the nifty financial engineering which enabled homeowners to use their
houses as ATMs, thus increasing the magnifier effect of the sector. Those days
are long gone….which is not necessarily a bad thing.

Cooling investment in equipment is
also reflected in recent orders for durable goods, which is considered a
trusted barometer of future economic prospects. The new orders data for core
capital goods decreased 0.6% from September to October. More worrisome is the
establishment of a trend, which has seen the three-month moving average in
negative territory for the past four months.

PMI: A Good Harbinger for 2014?

The aforementioned GDP data for
recent quarters, by definition is backward looking. Like the new orders for
capital goods data, certain components of the ISM’s Purchasing Manager’s Index
are also regarded for their ability to gauge the future path of the economy.
This report takes the pulse of managers in the trenches, those actually writing
the checks. If they don’t have confidence in future prospects, the checkbook...for
payroll, increased production and equipment purchases….likely stays in the desk
drawer.

Fortunately, as seen above, recent
data have impressed with many key sub-indices of the PMI having greatly
accelerated over the latter half of 2013. New orders and production have led the
charge, whereas employment, has slightly lagged (but still registered its
strongest gain since early 2012). The PMI is a diffusion index where numbers
greater than 50 indicate expansion in the manufacturing sector. Not only has
the headline PMI number been above 50 since late 2009, it is well above 42,
which is the threshold indicating growth in the broader economy. Why does 42 in
the manufacturing sector infer growth in the overall economy? The answer is in
the changing composition of the workplace. Manufacturing has been in decline
for decades so even in expansionary years, the nation’s factories continue to
atrophy.

Job Gains: Belated Growth…And In The Wrong Places

The diminishing fortunes of the
nation’s manufacturing sector are also on display in the jobs data. Since 1990,
manufacturing jobs, as a share of nonfarm payrolls has fallen from 16.3% to
8.8%. In its place are increases in dubious
sounding service sector categories like hospitality and leisure, which have
seen their share of total payrolls rise from 8.5% to 10.4%.

Historically, manufacturing jobs have
been key drivers of the economy as they offered solid wages and opportunities
to build skills. On the contrary, in a service economy, one can froth a latte
only so many ways. Just as important,
the sector’s workers, confident in their futures, would enthusiastically
partake in the ever so American tradition of rampant personal consumption, thus
creating an outsized magnifier effect, benefiting the entire economy.
Manufacturing still offers plumb positions, but the landscape is different. The
current emphasis is on intelligent manufacturing, which is a euphemism for
automation and fewer workers. One guy with a laptop in a control room can do
the tasks it took a dozen to complete only a few decades ago. This trend has
resulted in the sector losing the critical
mass of workers necessary to fuel ancillary segments of the economy. Now
only the local Prius salesman and yoga instructor benefit from this more highly
skilled….yet much leaner….workforce. Need numbers to back this grim claim? In
2007 the nation’s factories employed 14 million workers. During the recession,
it lost 2.5 million of those. In the mother of all jobless recoveries, it has
only clawed back 554 thousand of those positions, a paltry 22%.

Aggravating the travails of the
nation’s factory workers, is the slow pace of overall jobless growth. As seen
above, the nation still has nearly one million fewer jobs than it did at the
outset of the recession…and it has taken six (!!) years to reach this point. The
composition of the meager job gains does not help matters. Since 2008, workers
in part-time positions for economic
reasons (i.e. that’s their only option) have risen from 3.1% of nonfarm
payrolls to 5.2%.

Such part-time workers, along with
the unemployed and those marginally attached to the workforce, are components
of the broad U-6 unemployment rate which remains a depressing 13.8%. The
chances of this bulging bucket, by historical standards, being strong
contributors to personal consumption during the Christmas shopping season (and
beyond), in economic terms, is zilch.

A Cold Shower

The take-away from recent data is
that the bifurcation of the American economy continues. If one has mad
engineering skills or owns a Boulder County yoga studio, things are rolling
along. For those ill-prepared for a complex 21st century workplace,
prospects simply don’t look good.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.